You want volatility?

Yesterday was not a good day to be long stocks – in any country. In China the market dropped nearly 3% in the first half hour of trading, and then took off another 3% over the rest of the day, with the SSE Composite closing the day at 1723, down 6.3%. A number of large companies went down by their 10% daily limit, putting pressure on stocks to decline further when the market reopened today.

And that is exactly what happened this morning – the SSE Composite ended the morning down more than 3% for the day, before suddenly turning around and shooting up nearly 110 points to close the day at 1772, up 2.8% for the day. What drove the market down yesterday and this morning, not surprisingly, was continued concerns about the global economy and corporate profitability domestically.

Some policy-makers are very worried, from what I hear, although there is more pressure than ever on the media to downplay the extent of the crisis. On Sunday Governor Zhou of the PBoC told the Standing Committee of the National’s People Congress that the nation’s financial system was faring better than others, but that the crisis was intensifying and hurting the world’s economies so much that it had complicated the country’s efforts to use macroeconomic control measures.

Although most of the local media carried a more positive spin (typical was the People’s Daily: “Despite the impact of the global financial crisis, Zhou said, we should recognize that the overall economic condition is good, our financial institutions are generally strong, with increased profit-making and risk-fending abilities, market liquidity on the whole is ample and our financial system is sound and safe.”), his message was not particularly upbeat. He warned that “At present the external dependence of our economy is high, so the slowdown in the global economy and the reduction that brings in external demand will inevitably have a negative impact on our economic development.” He also said the fight against inflation was not over, claiming that in spite of the recent decline, “there is a lot of uncertainty in China’s inflation trend.”

Today however the Hong Kong market, after some of the worst days in its history, suddenly and for reasons I don’t fully understand (probably more to do with technical factors, like short-covering) suddenly turned around and surged over 14% – in the excitement driving Shanghai and Shenzhen as well as much of Asia with it. I am not terribly confident that this represents a turnaround – although as in every hefty rally there was no shortage of analysts hailing the bottom of the market. I think international markets are still too rattled and there is still likely to be more pressure on liquidity. It is especially worth keeping an eye on South Korean markets and other neighboring countires.

There was actually some recent good news, although it had little to do with the stock market’s turnaround today. The PBoC reported on its website that the average NPL ratio for China’s banks declined from to 5.49% by the end of September. Of course almost all the improvement in the ratio has come from loan growth, so more to the point, in the past three months total NPLs were roughly flat at RMB 1.27 trillion (just under $190 billion). Still, NPLs were up in the first half of the year and the outlook for next year is likely to be worse. For what its worth yesterday’s Bloomberg reports the following:

China’s six largest publicly traded banks may report a 20 percent increase in soured debt in 2009, according to BNP Paribas SA’s estimate.

Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Bank of China Ltd., Agricultural Bank of China and Bank of Communications Ltd., the nation’s five- largest lenders, had 1.11 billion yuan of bad loans as of Sept. 30, representing 7.35 percent of their total advances, according to today’s statement. Smaller national lenders, known as joint- stock banks, had a bad loan ratio of 1.59 percent, while city banks had 2.54 percent of their lending unpaid. The banking industry boosted its assets by 17.2 percent to 59.3 trillion yuan by September, the regulator said in a separate statement today.

NPL predictions, of course, depend on how the economy develops over the next few months and quarters, and that will itself depend crucially on what happens in the rest of the world. Last night I spoke with a close friend of mine in New York who owns a hedge fund, and he seemed to think that the problems were far from over. His biggest concern was that pension funds and endowment funds were sitting on huge losses and would be forced to withdraw money even from the best performing hedge funds, thereby putting more pressure on liquidity and prices. He seemed very, very worried. Let’s hope he is over-reacting.

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.